Financial Intermediation and the Post-Crisis Financial System Hyun - - PowerPoint PPT Presentation

Financial Intermediation and the Post-Crisis Financial System

Hyun Song Shin 8th BIS Annual Conference Basel, June 25-26, 2009

Outline

• Lessons on financial system architecture

from global financial crisis

• Implications for

– Size of financial sector relative to real economy – Securitization – Financial regulation – Accounting standards – Monetary policy

Stylized Financial System

ultimate claim holders ultimate borrowers

Non- financial firms

govt

Households

Households Pension funds Insurance companies Rest of world

direct credit Treasury & municipal bonds corporate bonds

Stylized Financial System

ultimate claim holders ultimate borrowers

Non- financial firms

govt

Households

Households Pension funds Insurance companies Rest of world

direct credit Treasury & municipal bonds corporate bonds

Banking (intermediary) sector

intermediated credit equity debt claims deposits financial paper MBS, ABS… mortgages corporate credit…

US Financial Intermediaries Total Assets (2007Q2)

ABS Issuers 4.1 Credit Unions 0.8 Broker Dealers 2.9 Savings Inst. 1.9 Finance Co. 1.9 Commercial Banks 10.1 GSE Mortgage Pools 4.5 GSE 3.2 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 Market-Based Bank-Based

$ Trillion

Holding of US Home Mortgages by Type of Financial Institution

0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 1980Q1 1982Q1 1984Q1 1986Q1 1988Q1 1990Q1 1992Q1 1994Q1 1996Q1 1998Q1 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1 $ Trillion 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 Agency and GSE mortgage pools ABS issuers Savings institutions GSEs Credit unions Commercial banks

Market-Based and Bank-Based Holding

• f Home Mortgages

1 2 3 4 5 6 7 1980Q1 1982Q1 1984Q1 1986Q1 1988Q1 1990Q1 1992Q1 1994Q1 1996Q1 1998Q1 2000Q1 2002Q1 2004Q1 2006Q1 2008Q1 $ Trillion 1 2 3 4 5 6 7 Market-based Bank-based

Short Intermediation Chain

households mortgage bank households

deposits mortgage

Long Intermediation Chain

households households

ABS mortgage

securities firm commercial bank money market fund ABS issuer mortgage pool

MBS Repo Short-term paper MMF shares

What Are the Advantages of the Long Intermediation Chain?

• “Securitization enables dispersion of credit

risk”

• “Long chains promote more efficient

maturity transformation”

– “Households want short, liquid claims” – “Shadow banking system gives them what they want”

But Evidence in this Crisis Points the Other Way

• Securitization has concentrated risks in

leveraged sector

• Biggest growth in short-term debt was

between financial intermediaries

• Financial intermediaries have become more

intertwined

– “CoVaR” Adrian and Brunnermeier (2009)

Exposure to Subprime

Total reported sub-prime exposure (US$bn) Percent of reported exposure Investment Banks 75 5% Commercial Banks 418 31% GSEs 112 8% Hedge Funds 291 21% Insurance Companies 319 23% Finance Companies 95 7% Mutual and Pension Funds 57 4% Leveraged Sector 896 66% Unleveraged Sector 472 34% Total 1,368 100%

Source: Greenlaw, Hatzius, Kashyap and Shin (2008)

Overnight repos, Financial CP and M2 (weekly, July 6 1994 as base date)

Apr 29 2009 Mar 19 2008 Aug 8 2007

2.37 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0

Jul 6 1994 Jan 18 1995 Aug 2 1995 Feb 14 1996 Aug 28 1996 Mar 12 1997 Sep 24 1997 Apr 8 1998 Oct 21 1998 May 5 1999 Nov 17 1999 Jun 7 2000 Dec 20 2000 Jul 4 2001 Jan 16 2002 Jul 31 2002 Feb 12 2003 Aug 27 2003 Mar 10 2004 Sep 22 2004 Apr 6 2005 Oct 19 2005 May 3 2006 Nov 15 2006 May 30 2007 Dec 12 2007 Jun 25 2008 Jan 7 2009 Overnight repo Financial CP M2

Apr 29 2009 Aug 8 2007 Aug 12 1998 Sep 12 2001 Sep 10 2008

20% 30% 40% 50% 60% 70% 80% 90%

J u l 4 1 9 9 J a n 3 1 9 9 1 A u g 2 8 1 9 9 1 M a r 2 5 1 9 9 2 O c t 2 1 1 9 9 2 M a y 1 9 1 9 9 3 D e c 1 5 1 9 9 3 J u l 1 3 1 9 9 4 F e b 8 1 9 9 5 S e p 6 1 9 9 5 A p r 3 1 9 9 6 O c t 3 1 9 9 6 M a y 2 8 1 9 9 7 D e c 2 4 1 9 9 7 J u l 2 2 1 9 9 8 F e b 1 7 1 9 9 9 S e p 1 5 1 9 9 9 A p r 1 2 2 N

• v

8 2 J u n 6 2 1 J a n 2 2 2 J u l 3 1 2 2 F e b 2 6 2 3 S e p 2 4 2 3 A p r 2 1 2 4 N

• v

1 7 2 4 J u n 1 5 2 5 J a n 1 1 2 6 A u g 9 2 6 M a r 7 2 7 O c t 3 2 7 A p r 3 2 8 N

• v

2 6 2 8

Repos and Financial CP as Fraction of M2 (weekly)

Source: Adrian and Shin (2009)

US Institutions’ CoVaR

IMF Co-Risk Measures (March 2008)

Source: IMF GFSR (April 2009)

Multi-layered Financial System

Source: Haldane (2009)

Global Interconnectedness

Source: Haldane (2009)

Relative Size of Intermediary Sector

Total Assets of Four Sectors [March 1954 =1]

(Source: Federal Reserve, Flow of Funds)

100 200 300 400 500 600 700 800 900

1954Q1 1956Q3 1959Q1 1961Q3 1964Q1 1966Q3 1969Q1 1971Q3 1974Q1 1976Q3 1979Q1 1981Q3 1984Q1 1986Q3 1989Q1 1991Q3 1994Q1 1996Q3 1999Q1 2001Q3 2004Q1 2006Q3

Non-financial corporate Households Security Broker Dealers Commercial Banks

Total Assets (Log Scale) [March 1954 =1]

(Source: Federal Reserve, Flow of Funds)

1980Q1

1 10 100 1000

1954Q1 1957Q1 1960Q1 1963Q1 1966Q1 1969Q1 1972Q1 1975Q1 1978Q1 1981Q1 1984Q1 1987Q1 1990Q1 1993Q1 1996Q1 1999Q1 2002Q1 2005Q1 2008Q1

Non-financial corporate Households Security Broker Dealers Commercial Banks

Procyclical Leverage of Five US Investment Banks

1998-4 2007-3 2007-4 2008-1

• 20
• 10

10 20 Total Asset Growth (% Quarterly)

• 20
• 10

10 20 Leverage Growth (% Quarterly)

Source: Adrian and Shin (2007)

6/30/1987 9/30/1998 12/30/2007 3/30/2009 10 14 18 22 26 1986 1989 1992 1995 1998 2001 2004 2007

Leverage

US Primary Dealer Mean Leverage

All Primary Dealers - Through 2008Q4

3/30/2008 15 20 25 30 35 40 1986 1989 1992 1995 1998 2001 2004 2007 Leverage

All Primary Dealer Mean Leverage

New Issuance of Asset Backed Securities in Previous Three Months

50 100 150 200 250 300 350 Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 Mar-04 Sep-04 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 $ Billions

Other Non-U.S. Residential Mortgages Student Loans Credit Cards Autos Commercial Real Estate Home Equity (Subprime)

Source: JP Morgan

Biggest Damage is Done in Contractions

ultimate claim holders ultimate borrowers

Non- financial firms

govt

Households

Households Pension funds Insurance companies Rest of world

Banking (intermediary) sector

But Seeds of Crises Are Sown in Expansions

Banking (intermediary) sector ultimate claim holders ultimate borrowers

Non- financial firms

govt

Households

Households Pension funds Insurance companies Rest of world

How To Moderate Balance Sheet Boom/Bust Cycles?

Individual Bank Balance Sheet

Assets Liabilities Individual bank Loans to firms, households Claims on other banks Liabilities to non-banks (e.g. deposits) Liabilities to other banks Equity

Balance Sheet for Banking Sector

Assets Liabilities Banking sector Total lending to ultimate borrowers (firms, households govt) Total debt liabilities to non-banks Total equity

Slow moving: increases in line with household wealth

Aggregate Balance Sheet Identity

  

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  

  

n i i i i n i i n i i

e z e y

1 1 1

1 

Total lending to ultimate borrowers Total equity of intermediaries Total debt liabilities To non-banks

Booms

• Higher leverage of financial intermediaries
• Larger balance sheets of intermediaries
• Greater intertwining of intermediaries

– Longer chains – Maturity mismatch to sustain longer chains

Architectural Analogy

• Adding extra capacity (more rooms) to a

house when constrained by limited footprint

– The only way is to build up (like a Manhattan skyscraper) – Except that Manhattan skyscraper is planned ahead, as a coherent whole – Better analogy is adding extra floors to a building without anticipating future floors on top

Sutyagin House in Archangel

Busts

• Deleveraging
• Shrinking balance sheets
• Unraveling of interbank lending

– Runs – Retrenchment

Northern Rock Northern Rock

Composition of Northern Rock's Liabilities

(June 1998 - June 2007)

20 40 60 80 100 120 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07

Billion pounds

Equity Other Liabilities Securitized notes Retail Deposits

Northern Rock's Leverage

June 1998 - December 2007

10 20 30 40 50 60 70 80 90 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Leverage on total equity Leverage on shareholder equity Leverage on common equity

What Prescriptions for Better Functioning Intermediary Sector?

Approach 1: Moderate Fluctuations in Leverage through Countercyclical Capital Regulation

  

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  

  

n i i i i n i i n i i

e z e y

1 1 1

1 

• Leverage cap (e.g. Switzerland)
• Countercyclical capital targets (Geneva Report)

Approach 2: Moderate Fluctuations in Equity through Forward-looking Provisioning

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  

  

n i i i i n i i n i i

e z e y

1 1 1

1 

• Spanish Statistical Provisioning
• Pigovian Tax (Geneva Report)

Approach 3: Shortening Intermediation Chains through Development of New Instruments

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 

  

  

n i i i i n i i n i i

e z e y

1 1 1

1 

Covered bonds

• Danish mortgage bonds
• German pfandbrief bonds

Long Intermediation Chain

households households

ABS mortgage

securities firm commercial bank money market fund ABS issuer mortgage pool

MBS Repo Short-term paper MMF shares

households households

ABS mortgage

securities firm commercial bank money market fund ABS issuer mortgage pool

MBS Repo Short-term paper MMF shares

mortgage bank

covered bonds mortgage

Investors in Covered Bonds

Asset management 47% Pension fund 9% Insurance 2% Retail/Commerc bank 9% Private bank 6% Broker/dealer 17% Hedge fund 2% Intermediary Sector 34% Central bank & Treasury 8%

Source: SIFMA (2009)

Hurdles to be Overcome

• Seniority of depositors (and hence deposit

insurance agency)

– In the United States, FDIC policy is to restrict covered bonds to 4% or less of total liabilities – An alternative is to develop specialist “narrow” covered bond banks who do not take deposits and only issue covered bonds

• Model provided by mortgage banks in Denmark

Some Features of Possible Future Financial System

• Smaller intermediary sector

– Especially securities sector

• Shorter intermediation chains

– Less profitable – Less maturity transformation

• With regulatory brakes
• Monetary policy?
• Accounting standards?